Bed Bath and Beyond: Capital Structure Decision (HBR Case Study)

IntroductionBed Bath & Beyond (BBBY) was founded in 1971 by Warren Eisenberg and Leonard Feinstein. BBBY held its initial public offering in June 1992, on the NASDAQ exchange. The company utilizes the “big box” retail concept and focuses its product offerings around domestics merchandise and home furnishings. Since its IPO BBBY has been favored by equity investors and long considered one of the best performing retail companies. They have never missed an earnings estimate and have experienced a fortyfold increase in stock price from the original $17 per share IPO. The company introduced its ﬁrst superstore in 1985 and have since underwent large scale expansion operating 575 stores by the end of the ﬁscal year 2003. BBBY also owned and operated 30 Harmon stores and 24 Christmas Tree Shops stores by 2003. (See appendix four for SWOT analysis)

The ProblemBed Bath & Beyond has always conducted business under the old fashioned premise that “cash is king, and debt is bad”. As of late their capital structure has become a big issue amongst investors. They are concerned that the current unlevered structure is not maximizing value and are wary of the risks associated with the companies large and growing cash balances. Currently BBBY is facing the issue of trying to decide wether their current capital structure is optimal moving into the future, and if not, what decisions they need to make to achieve optimization. The following analysis will outline the key factors inﬂuencing this decision and ultimately suggest a course of action.

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Case Analysis
Capital StructureBBBYʼs capital structure is not optimal, as BBBY has a large cash position and they do not issue any debt nor do they pay any dividends during their operation. M&M proposition I states that the value of ﬁrm is independent to its capital structure and therefore the mix between debt and equity is irrelevant. However assumptions under the M&M proposition are unrealistic in the real world, so the idea that an optimal capital structure is unattainable is discarded. Achieving the optimal capital structure depends on the mixture of debt to equity, depending on the amount of debt, it can help maximize the value of the ﬁrm while minimizing WACC. Another reason BBBY should consider taking on some debt is that they have more than enough cash to cover their expenses. Issuing debt can act as a positive signal to investors that they are able to make timely payments and are ﬁnancially stable.

The tradeoff theory of capital structure states that a value-maximizing ﬁrm will balance the value of interest tax shields and other beneﬁts of debt against the costs of bankruptcy and other costs of debt, to determine an optimal level of leverage for the ﬁrm (KISGEN, 2006). One potential reason why BBBY may not be taking advantage of the tax shields could be that they want to stay ﬂexible in the industry and avoid costs of ﬁnancial distress. According to Exhibit 8 from the case, Pro Forma 2003 of BBBY with 40% debt to total capital, the interest coverage ratio is 22.519 ($644,836/28,635) and the debt to equity ratio is around 66.67% ($636,328/954,492), which coincides with AA credit rating and the default rate, which

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is 1.31% (Exhibit 7A). From Exhibit 2 in the case, we can ﬁnd BBBYʼs total assets on Feb. 29, 2004 are $2,865,023 and taking the value of 15% and the bankruptcy cost for BBBY is approximately $5629.8 (Heitor Almeida, 2004). Meanwhile, from Exhibit 8, the taxes on Pro Forma 2003 is $237,237, which is $12,838 ($250,075-237,237) less than actual 2003, which results in the tax beneﬁt generated from issuing debt is -$15,797 ($12,838-28,635). It is obvious to conclude that, with the implication of tradeoff theory, the pro forma 40% debt to total capital in 2003 is not the optimal leverage ratio for BBBY.

The pecking order theory argues that ﬁrms will generally prefer not to issue equity due...

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Bed, Bath and Beyond (BBBY) currently has $400 million more in cash than they need for ongoing growth and operations requirements. While the company is financially sound analysts and investors worry about the company’s capitalstructuredecisions. Investors do not want to see that much cash on the books and worry that the current capitalstructure is not the most effective for the future. They prefer that BBBY change their capitalstructure by paying out excess cash and issuing debt. This could allow BBBY to improve their return on equity and raise earnings per share. Given the low interest rates available it seems like the perfect time for BBBY to add debt to its capitalstructure. Until now they company has always had a “cash is king, debt is bad” mentality so the decision to add debt is not one being taken lightly.
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BedBath & Beyond: The CapitalStructureDecision
“BedBath & Beyond’s earnings report could have been called BedBath & Brag,” according to
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Union, New Jersey, had never missed an earnings estimate. For fiscal year 2003 (ending February 28,
2004) BBBY announced net income of $339 million on net sales of $4.5 billion, representing 22
percent growth in revenue and 32 percent growth in income over the previous fiscal year (see Exhibit
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summer 2003, the growing cash position of the company was causing return on equity to deteriorate.
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sheet was one possibility. In early 2004 interest rates were at an all-time low, making it an attractive
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